Don't Let The Pundits Fool You, A Tax Hike On The Rich Is Paid For By The Poor

There seems to be a certain comfort level in proposing income tax rate hikes on the amorphous category known as the “rich” as a part of a deal to avoid the so-called “fiscal cliff.” After all, an income tax rate hike in the top tax bracket isn’t likely to really do much to harm to those in lower brackets, right?

First, consider this: many of the tax returns filed in the upper brackets are small businesses and individual entrepreneurs who are “pass through entities” that pay their businesses taxes through the income tax code. According to IRS data analyzed by the Tax Foundation, 66 percent of all “pass through” taxable income falls into the category of earners in the $250,000-plus range. Lower the bar to $100,000 in income and the percentage grows to 87 percent. This is partly the reason that tax cuts on higher levels of income can generally lead to better economic outcomes like more job creation in those firms: they lower the tax barriers to business expansion.

Secondly, the idea that tax hikes at the top can’t have an effect on the poor is actually faulty. An emerging consensus now indicates a rising tide of entrepreneurial activity is a factor that links low tax burdens and improvements in welfare and wealth-creation for those at the bottom. Entrepreneurial endeavors among the working poor – like starting a beauty salon or food truck business – can certainly help move people out of poverty. But running a business isn’t the only way out of poverty, either. New entrepreneurial activity also provides employment opportunities for the poor that would not otherwise be there.

This isn’t “trickle-down economics” in which most of the wealth creation goes to those at the top and, if there’s any left, then it flows to those at the bottom of the income spectrum. Instead, this unlocks an entirely new river of activity that flows from the bottom up. Conversely, entrepreneurship generally is stunted when taxes rise.

The consensus on the entrepreneurship and poverty connection has been spurred by a multitude of evidence over the past twenty years. A classic study published by the National Bureau of Economic Research in 2000 concluded that, “for individuals who began toward the bottom of the earnings distribution, continuous experience with self-employment was a successful strategy for moving ahead (relative to wage-earners), both in the short- and long-term.”

Furthermore, a five-year study by the Aspen Institute in the mid-1990s that followed more than 1,500 low-income entrepreneurs across the nation revealed much the same. Close to three-fourths (72 percent) of those low-income entrepreneurs experienced almost a tripling in their household income. Perhaps most impressive, more than half (53 percent) had moved out of poverty by the end of the study. Another Aspen study found that those who were on welfare before becoming entrepreneurs were able to generate enough income on their own that, on average, the amount of public assistance that these entrepreneurs accepted declined by 61 percent between 1988 and 1992.

We can draw some further conclusions by the various policies pursued in the states during the last economic boom from 2001 to 2007. The poverty rate went down in many states during that period, up in others, and some states were better at lowering the poverty rate than others. What mattered greatly was the level of entrepreneurial activity in a state. As I explain in a new report published by the Goldwater Institute, the relationship between the growth in entrepreneurship and poverty reduction is evident by looking at a basic form of entrepreneurship – the number of non-farm sole proprietorships and general partnerships as a percentage of overall employment as measured by the U.S. Bureau of Economic Analysis. After controlling for demographic variables as well as other policy variables that have the potential to reduce the poverty rate – such as the welfare-to-work policies that each state pursued – the results indicate that higher average rates of entrepreneurship in a state did indeed correspond to bigger declines in poverty. In fact, for every one percentage point increase in the number of entrepreneurs in a state, the average state saw a two percent decline in the poverty rate.

So, what does that have to do with tax policy and demands to soak the so-called “rich?” What we’ve seen at the state level is that high tax rates and high general tax burdens can impede poverty reduction largely because they decrease the growth rate in entrepreneurial activity.

Research published by the U.S. Small Business Administration illustrated how a number of different tax policies affected the level of entrepreneurship between 1989 and 2001. The authors found that high top marginal income tax rates tended to decrease the share of entrepreneurship in a state. So did high overall tax burdens. And, finally, they also discovered that high rates of entrepreneurship are related to declines in the poverty rate.

The Goldwater study extends that analysis through 2007 and shows that there is still a strong connection between levels of entrepreneurship in a state and the general effective tax burden of a state: for every 1 percentage point increase in the tax burden, there’s a corresponding 1 percentage point drop in the entrepreneurship rate.

So, tax hikes at the upper end can indeed inhibit growth in entrepreneurship and the subsequent decline in poverty that often comes with it. Tax hikes are not the only factors that can ultimately inhibit entrepreneurship, of course, but they obviously don’t help. As with many misguided economic policies, the adverse effects can’t be contained. Policymakers in Washington need to keep in mind that, among other things, hiking taxes on the rich can actually hurt the poor.